Reverse Mergers

Reverse Mergers
Tough initial public offerings are perhaps the most sought-after form of financing, the fact is, surprisingly few companies can hope to negotiate their way through the tortuous process. This truth leads to a nasty Catch-22. Many promising small companies cannot obtain funding because they are private. However, without funding, they can't hope to grow to the size that would allow them to go public.

Why is being a private company anathema to the capital-formation process? Because many investors believe that even if the company does well, without an exit strategy to get their money out, they'll never realize a substantial return on their investment. There might be some merit to this thinking; however, the other side of the coin is that a patiently funded company that realizes its true potential has numerous options for rewarding its shareholders.

If you're convinced going public is the best way to find the funding you need, there's an alternative to the typical IPO that's less burdensome and may be equally lucrative: a reverse merger. In a reverse merger, a private company acquires an already public, though typically dormant, company and becomes public as a result. Though completing a reverse merger is only the first step in receiving funding as a public company, it can lay the groundwork for substantial capital growth.

Following are some of the primary benefits you can reap with a reverse merger:

Imperviousness to market conditions - Conventional IPOs are risky for companies to undertake because the deals depend on market conditions over which you have no control. If the market is off, the underwriter may pull the offering. The market doesn't even need to plunge wholesale. If a company seeking an IPO is in an industry that's making unfavorable headlines, investors may shy away from the deal, causing it to run out of gas on the runway. But with a reverse merger, the deal rests on whether the shell company likes your company enough to be acquired by it. Market conditions have almost no bearing.
Compressed timetable - Regular IPOs can drag on for a year or more from when the idea pops into your head until you actually get a check. Unfortunately, when a company transitions from an entrepreneurial venture to a real public company fit for outside ownership, senior management's time is at its most valuable. Spending it in seemingly endless meetings and drafting sessions can have a disastrous effect on the growth the offering is predicated on and even nullify it. In addition, during the many months it takes to put together an IPO, market conditions can deteriorate, closing the IPO window on a company. By contrast, a reverse merger can be completed in 45 days.
Reduced expenses - For a real IPO, it can cost as much as $200,000 just to get a preliminary prospectus on the street. To actually bring the deal to the closing table, the costs increase. A reverse merger, however, can be done for only $50,000 to $100,000.
Corporate tax shelter - Many shell companies have what's known as a tax-loss carry forward. This means losses incurred in previous years can be applied to income in future years. When this occurs, future income is sheltered from income taxes. There's a better-than-average chance the shell you meet will offer this opportunity. (As discussed in the next section, however, the shell company's history can rub off on you, which turns out to be one of the biggest drawbacks to reverse mergers.)
More ways to raise money - The primary reason to do a reverse merger is the greater number of financing options that become available to companies once they have gone public. These include: 1. The issuance of additional shares in a secondary offering. 2. Exercise of warrants. Warrants are options that give the holder the right to purchase additional shares in a company at a predetermined price. When many shareholders with warrants--which a public company can easily issue--exercise their option to purchase additional shares, the company receives an infusion of capital. 3. Private offerings. Many more investors will step up to the plate for a private offering of shares once they know there's some sort of mechanism in place for them to resell their shares if the company succeeds. Most investors realize that even a successful company may not be able to go public if market conditions are off. But a company that is already public . . . that's a different story. If it succeeds, there's a greater likelihood of developing a market for its common stock that accurately represents the company and lets investors sell their shares.

Reverse mergers aren't for everyone. There are several drawbacks to this financing technique. Among the disadvantages:
Image - Reverse mergers have accumulated their share of controversy over the years for a few reasons. First, most reverse mergers start with dormant public companies. Usually they fell into dormancy because of failure in their line of business. As a result, there may be an angry group of shareholders somewhere in the deal. Furthermore, the chances of some irregularity occurring in the trading, most likely unknown to the company, are high. That's because most reverse transactions initially trade on the Pink Sheets or the OTC Bulletin Board, the least regulated tiers of the market.
Unknown shareholders - At the end of the day, the private company that acquires a public one is left with an unfamiliar shareholder base with which it has had no previous interaction. These shareholders can place a significant downward pressure on the company's stock by continually selling their shares as a new trading market develops. Also, creditors or other parties that suffered in the past because of the failures of the predecessor company can come out of the woodwork and make claims against the new management.
Indirect route to capital - Reverse mergers represent a way to open avenues to financing for a company without actually financing it. Though they are theoretically quick and easy, like any securities transaction, reverse mergers contain enough wrinkles to draw out the process. But in most instances, just consummating the reverse merger transaction is only the halfway point in a company's pilgrimage to growth capital. When it's done, the company must still go out and beat the bushes for the cash it needs.
Difficulty becoming a real public company - An exciting private company may have taken control of a dormant public company, but that doesn't necessarily mean other investors will sit up and take notice. In fact, the only investors who tend to care about the change of control are those who invested in the original company.
Often their interest is mercenary - They simply want to know when the new company will succeed to the point where they can recoup their money. As a result of their relative obscurity, most reverse mergers find that their stock doesn't trade much. Moreover, company executives and principals have a hard time attracting enough investors to their stock to create the kind of trading and liquidity that is the benchmark of a conventional public company.